Borrowers under variable rate commercial loans commonly enter into interest rate hedge agreements to eliminate or reduce their exposure to the interest rate risk of their variable debt service obligations. While much recent commentary has been devoted to modifications, waiver and defaults under commercial mortgages and other commercial loans, careful attention should also be paid to how any contemplated action under the loan affects the hedge agreement and whether any corollary action needs to occur with respect to the hedge. The following are some issues to bear in mind with respect to interest rate hedges in the current market environment, particularly if the borrower and lender are considering any waiver or modification to the loan agreement or if a loan event of default may be triggered.
Types of Hedge Agreements
There are generally two categories of hedge agreements that borrowers utilize in this context. The first is an interest rate cap, which is technically a series of interest rate options that correspond to the payment dates under the loan. The borrower pays a premium up front and receives a payment if interest rates are above the strike or cap rate at the time of determination, with any such payment offsetting the borrower’s debt service payment in excess of the cap. The second is a fixed for floating interest rate swap, where the borrower pays a periodic fixed rate in exchange for receiving a floating rate payment aligned with its variable rate under the loan. Because interest rate caps are fully paid up front, they generally do not involve the hedge provider having credit exposure to the purchaser, whereas interest rate swaps involve the potential for bilateral credit exposure. That distinction becomes important in contexts of loan default or a waiver or modification that may require a modification of the hedge. Since interest rate swaps involve credit exposure, the hedge provider (who is usually also the lender or one of the lenders) typically takes a pro rata security interest in the loan collateral and may require any guaranty of the loan to be extended to the interest rate swap.
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